Alcoa opposes LME rule change

NEW YORK  The aluminum markets issues could be fixed by new regional premium contracts and transparent data reporting, not by the proposed changes to London Metal Exchange warehousing rules, which will only complicate and prolong the situation, according to Alcoa Inc.

The Pittsburgh-based aluminum producer called on the LME to establish regional premium contracts for four locationsthe U.S. Midwest, Rotterdam duty paid, Rotterdam duty unpaid and c.i.f. Japan.

It also reiterated its call for the LME to improve transparency by establishing a Commitments of Traders style report, similar to that established by the Commodity Futures Trading Commission (CFTC).

The growing spread between the LME price and premiums is the real problem, not the amount of time it takes to get material out of storage, Tim Reyes, Alcoas president of Materials Management, said in a letter sent to Matt Chamberlain, the LMEs principle architect of the current warehouse proposals and new head of business development.

"While satisfying a short-term public relations need, imposing this rules change will have serious short and long-term impacts, encouraging the movement of LME inventory to invisible, off-warrant inventory, increasing the call for regulation of the LME and undermining confidence in (Hong Kong Exchanges & Clearing Ltd.), its understanding of the aluminum industry and its motivation for purchasing the LME," Reyes said.

"We believe that the proposed changes constitute a major market intervention that will aggravate the lack of transparency that has had a damaging impact on the aluminum industry and will do nothing to help our customers manage their exposure to aluminum pricing," he added.

Alcoas letter comes in response to proposed changes to the LMEs warehousing rules, designed to cut queues to access metal in storage and reduce premiums paid for physical delivery (amm.com, July 1).

Those proposals, which impose additional load-out requirements on warehouses with wait times of more than 100 days, are set to be voted on at the LMEs next board meeting in October.

"We encourage market users to contact us with their views," an LME spokeswoman said, adding that the exchange had no further comment until the conclusion of the consultation.

The companys analysis of the situation shows that metal is readily available and consumers arent waiting in queues.

The main problems with the proposals include the potential for higher warehouse rents and handling fees, along with the movement of metal off-warrant and out of regulatory oversight.

Metal leaving warehouses with queues beyond 100 days would also likely go to locations with lower queues and stay there invisibly until it was placed on warrant.

The letter also noted that material could shuffle between warehouses, while logistically constrained warehouses might be forced to refuse metal. This would create an artificial tightness, creating backwardations even at a time of market surplus.

"Instead of taking such a questionable action that massively interferes with supply and demand market dynamics, to maintain the credibility necessary to achieve those growth goals the LME needs to address pricing transparency immediately," Alcoa said. "If the proposed warehouse rule changes are implemented, it will say to existing and potential users of the exchange that the HKEx is willing to act carelessly and that the LME may not be the correct forum for their price discovery process."

The basic problem is that aluminum premiums, which rose to record highs at the same time as queues to access material soared to sometimes 18 months, are difficult to hedge in the current marketplace, Alcoa said.

"The current alternatives available to hedge premium exposure are illiquid and only available in the over-the-counter market. Credit exposure to financial premium swap counterparties limits liquidity and there are no visible benchmarks for forward premium prices necessary for valuing forward positions," Alcoa said in the letter.

The warehouse queue issue is a "red herring" driven by claims that it would reduce prices, despite the reality that aluminum prices have declined 40 percent in the past five years, according to Reyes, and by claims that it would increase supply despite a surplus of physical aluminum available to end market consumers.

The current LME system of warehousing bases delivery upon the sellers option; the buyer of an LME warrant doesnt know which location it will get in advance.

This deters consumers from using it irrespective of the queues, Alcoa said, adding that it is time for a physical market the size of aluminum to move beyond being based on a U.S. Midwest benchmark.

"Todays method for setting regional prices, by publication surveys, does not allow risk holders to effectively hedge their position," the company said.

"An exchange-traded premium contract will address the call for more transparency in how premiums are set. And a clearing system would enhance liquidity in the marketplace by allowing a greater portion of the market to participate," it added.

The LME must use its forum, platform and technology to "offer a transparent marketplace for these products to trade in the open market," according to Alcoa. "Through premium contracts, users will have the ability to trade a transparent, clearinghouse-backed product and value their forward positions on a daily basis."

Increased speculative trading with zero interest in physical metal delivery means the LME aluminum price doesnt reflect the fundamentals of the industry, Alcoa said in the letter.

Instead, the price is being driven by short-term macro-events: historically low interest rates and metal price contango, combined with the increased attractiveness of metal and other commodities as an asset class.